What are Preference Shares: Meaning, Types, And Features | 5paisa (2024)

Introduction

A company that wants to expand needs capital to invest. It raises capital by offering securities to public investors, institutions, and organizations. These securities are of various types. Investors can choose any form of security depending on the benefit they seek to enjoy from investing. These securities have a financial value that depends on the company’s performance.

They represent direct or indirect ownership of the company depending on how they are designed and the associated terms and conditions. A company can choose the type of securities it can offer and a certain quantum of the capital raised in the form of share capital. The main types of shares offered are Equity and Preference. This article defines preference shares.

What do you mean by preference shares

A company issues Preference shares to raise capital. Preference shares meaning or Preference stock represents ownership in the company. The capital raised becomes a part of the Preference share capital. These shareholders enjoy preference over common shareholders on the assets and capital of the company. They receive dividends before equity shareholders. They also have a prior claim on the company’s assets compared to common shareholders.

What are the main types of Preference Shares?

1. Cumulative preference share

Cumulative preference shares entitle the shareholder to dividend payouts even when it is not making profits. As the name suggests, the company pays due dividends to the shareholders when it has earned profits. The payouts to preference shareholders must be made before the common shareholders receive payouts. Sometimes an additional payout is awarded to the holders of these preference shares.

2. Non – cumulative preference shares

These are the type of shares where the company can decide if the shareholders are to receive dividends and not receive omitted or pending dividends. The shareholders do not have a right to claim dividends. Profits are used to pay dividends.

3. Participating preference shares

In this case, the shareholders can demand a surplus on the dividend if the dividend paid out to the common shareholders is greater than the predetermined amount. If the company is liquidated the Participating preference shareholder can demand a share of the surplus profits thus gained.

4. Non-Participating preference share

The shareholders of these preference shares will only get pre-determined dividends. They will not get a share from surplus profits.

5. Redeemable preference shares

These shares can be redeemed by the company at a predetermined rate and time. These provide an antidote to inflation for the companies.

6. Non-redeemable preference shares

These preference shares cannot be redeemed by the company in its lifetime. They can be redeemed only when the company is closing down.

7. Convertible preference shares

These shares can be converted to equity shares by the shareholder after a certain period at a fixed rate.

8. Non-convertible preference shares

These shares that cannot be converted to equity shares are called non-convertible preference shares. They get fixed dividends when the company exists and preferential dividend payout when the company is dissolved.

Features of Preference Shares

1. Preference shares have a preferential right or claim over the company’s assets or capital.
2. The shareholders receive a fixed, pre-determined dividend from the company and have priority over equity dividends.
3. Preference shareholders are paid before equity shareholders when the company is winding up.
4. Preference shares can be redeemed from the company.
5. They can be converted to equity shares.
6. Some preference shares are eligible to receive cumulative arrears of dividends if any.
7. Preference shares can be invested for medium to long-term periods as the risk associated with them is low compared to equity shares.

The share market, especially equity shares, is infamous for being volatile. The finance world is filled with stories of people who invested in equity shares losing their hard-earned money. In many instances, they are deprived of their life savings. By choosing preference shares, many investors can rest assured that their money is safe. Not only is it protected from the volatility that equity experiences, but they are also assured of getting the investment in the worst case when the company dissolves.

Advantage of Preference Share

Preference shares offer several advantages:

• Fixed Dividends: Preference shareholders receive a fixed dividend, often higher than common equity dividends, providing steady income.
• Priority in Payments: In case of company liquidation, preference shareholders have priority over common shareholders in receiving payments.
• Lower Risk: Compared to equity shares, preference shares are less volatile and carry lower risk, making them suitable for conservative investors.
• Convertible Options: Some preference shares can be converted into equity shares, allowing investors to benefit from potential capital appreciation.
• Cumulative Dividends: If dividends are missed, they accumulate and must be paid before any dividends to equity shareholders.
• Callable Feature: Companies can buy back preference shares, providing flexibility in managing capital.

Disadvantage of Preference Shares

Preference shares, while offering fixed dividends and priority over equity shares in terms of payouts, come with several disadvantages for investors:

• Limited Capital Appreciation: Preference shareholders generally do not benefit from the significant capital gains that equity shareholders might enjoy if the company performs exceptionally well. The returns are mostly limited to fixed dividend payments, making them less attractive for growth-oriented investors.
• Lack of Voting Rights: Preference shareholders typically do not have voting rights in the company. This limits their ability to influence key decisions or participate in important corporate matters like mergers, acquisitions, or management changes.
• Dividend Non-Guarantee: Although preference shares offer fixed dividends, these are not guaranteed. If the company faces financial difficulties, it may delay or skip dividend payments altogether, especially in the case of non-cumulative preference shares.
• Lower Liquidity: Preference shares are generally less liquid compared to equity shares. The market for trading preference shares is smaller, which can make it challenging for investors to exit their positions quickly or at a favorable price.
• Callable Nature: Many preference shares are callable, meaning the issuing company can repurchase them at a predetermined price. This can limit the investor’s potential returns if the shares are called when interest rates are lower.

These factors make preference shares a less favorable choice for some investors, especially those seeking growth, control, or liquidity.

Conclusion

The share market, especially equity shares, is infamous for being volatile. The finance world is filled with stories of people who invested in equity shares losing their hard-earned money. In many instances, they are deprived of their life savings. By choosing preference shares, many investors can rest assured that their money is safe. Not only is it protected from the volatility that equity experiences, but they are also assured of getting the investment in the worst case when the company dissolves.